Stock Pick of the Week: Buy Analog Devices Inc (ADI) – Very Attractive Rating

Do not worry if you have missed out on prior picks in the tech sector because I have another one for you. Like MSFT and IBM, I expect this pick to outperform the S&P 500 substantially. Since we picked it on 9/28/10, MSFT rose 10% while the S&P 500 rose 7%. Since we picked it on 8/17/10, IBM rose 14% while the S&P 500 rose 12%.

As detailed in our ETF report on the tech sector, tech stocks are far and away the most profitable. That sector’s returns on invested capital (ROIC) stand at 42.3%, which is more than double the S&P500 at 17.4%.

And this week’s stock pick of the week is no exception. Analog Devices Inc (ADI), one of December’s Most Attrac­tive Stocks, boasts a 54% ROIC. And like all of our Most Attrac­tive Stocks the com­pany has (1) high and ris­ing eco­nomic prof­its (as dis­tinct from account­ing prof­its) and (2) a cheap val­u­a­tion.

As shown in our free report on ADI, the company’s return on invested capital (ROIC) (54%) is in the top quin­tile of all the com­pa­nies we cover and its eco­nomic earn­ings are grow­ing faster then reported accounting earnings. During its lat fiscal year, ADI’s economic earnings rose by 283% while accounting earnings rose by only 187%. Digging through the financial footnotes, we found $15mm in non-operating/non-recurring charges that cause reported earnings to be understated.

At the same time, the stock’s val­u­a­tion implies that ADI’s prof­its will decline by 10% and never grow again. In other words, the stock mar­ket is pre­dict­ing a per­ma­nent decline of more than 10% in ADI’s prof­its. Given that most investors are not aware that the company’s operating profits are as strong as they are, the market is probably not giving ADI appropriate credit for its profitability.

In summary, the mar­ket is set­ting the profit growth bar quite low for this stock.

HIDDEN GEMS:

1. About $15 million in non-operating expenses (after-tax) cause reported earnings to be understated.
2. Our dis­counted cash flow analy­sis shows that ADI’s cur­rent val­u­a­tion (stock price of $37.18) implies that the company’s prof­its will decline by 10% and never grow again.
3. The com­pany grew its eco­nomic earn­ings by $283mm dur­ing its last fis­cal year.
4. Excess cash of $2,462.5mm or nearly 25% of its market cap

For details on what causes the dif­fer­ence between eco­nomic ver­sus account­ing prof­its, see Appen­dix 3 on page 10 of our report on ADI. See Appen­dix 4 to learn how ADI increased net operating profit after tax (NOPAT) by cut­ting costs and increased its NOPAT mar­gin from 13.4% to 26.4%. See Appen­dix 5 for details on how ADI reduced its invested cap­i­tal while revenue grew and raised its invested cap­i­tal turns from 1.38x to 2.04x. Appen­dix 7 (in the ROIC sec­tion) shows how the com­pany’s increase in NOPAT mar­gin and invested cap­i­tal turns result in an increase in ROIC (from 18.5%% to 53.9%) and eco­nomic earnings, which rose by $465.4mm.

In summary, ADI is gets our “very attractive” stock rating because its economic earnings are strong and growing while its valuation implies economic earnings will decline permanently by 10%.

ADI fits the risk/reward pro­file of a great stock to buy.

Note: Stock pick of the week is updated every Tuesday.